Understanding Money: Features, Forms, and Measurement

1. MONEY • What is Money? • 3 Distinguishing Features of Money: • .Medium Of exchange • .Unit of Account • .Store of Value

2. Medium of Exchange • Facilitates efficient economic transactions • Advantage over Barter Economy: • Double Coincidence of Wants Not Necessary • Promotes Specialization & Division of Labor

3. Unit of Account • Measure of Value in the Economy • Common Yardstick to Value Different Goods and Services

4. Store of Value • Enables agents to shift consumption across time, i.e., save now, consume later. • Other financial & Non-financial assets may also have this property. Money is distinguished by its Liquidity. • Money is unattractive as a store of value in an inflationary environment.

5. Forms of Money • Commodity Money: Money that is inherently valuable, e.g., Gold & Silver • Paper Money: Initially paper money used to be convertible into an equivalent amount in precious metals. More recently, no such convertibility : fiat money. • Checkable Deposits: Convenient, Safe & Useful for Large Transactions • Electronic Money: Debit Cards, Wire Transfers (FedWire, Clearing House Interbank Payments System) • Efficient • Concerns about Safety & Security

6. How Do We Measure Money? • Different Measures of Money Depending Upon What is Included and What is Not. • Usual Criterion for Qualifying as Money: Acceptability as Medium of Exchange

7. M1 • Also known as ‘Narrow Money’ • Includes • Currency • Travelers Checks • Demand Deposits • Other Checkable Deposits

8. M2 • Also known as ‘Broad Money’ • Includes • M1 • Small Denomination Time Deposits • Savings & Money Market Deposits • Non-Institutional Shares in Money Market Mutual Funds • Overnight Repos • Overnight Eurodollar Deposits

9. M3 • Includes • M2 • Large Denomination Time Deposits • Institutional Shares in Money Market Mutual Funds • Term Repos • Term Eurodollar Deposits

10. L • Includes • M3 • Short Term Treasury Securities • Commercial Paper • Savings Bonds • Banker’s Acceptances

11. DETERMINATION OF INTEREST RATES • How are Interest Rates determined by the Market ? • 2 Analytical Frameworks: • Loanable Funds Framework • Liquidity Preference Framework

12. Loanable Funds Framework • Supply & Demand for Bonds • Supply of Bonds is Equivalent to Demand for Loanable Funds. Similarly, Demand for Bonds is equivalent to Supply of Loanable Funds • Therefore, Demand-Supply Analysis for Bonds is equivalent to Demand-Supply Analysis for Loans

13. Demand for Bonds • As Bond Prices Increase, Demand for Bonds Declines • But Higher Bond Prices Imply Lower Interest Rates • Therefore, as Interest Rates Increase, Demand for Bonds Increases

14. Given the equivalence between Bonds Market Analysis and Loans Market Analysis, these figures can be represented as • The equilibrium interest rate is determined at the level at which Demand equals Supply

15. Changes in Equilibrium Interest Rates • Distinction between movement Along a Curve and Shifts in a Curve:  Change in quantity caused by a change in price, or interest rate: Movement along the curve  Change in quantity caused by a change in any other factor: Shift in the curve

16. Example of a Shift in the Demand Curve • People ‘Want’ to buy more bonds • At every price (interest rate) level, more bonds are demanded than before

17. Shifts in demand for bonds occur due to changes in • Wealth • When Aggregate Wealth in the Economy Increases, people have more money to invest in Financial Assets  Demand for Bonds Increases, i.e., Bond Demand Curve Shifts to the Right

18. Shifts in demand for bonds occur due to changes in • Expected Returns on Bonds Relative to Other Assets • When interest rate increases relative to other asset returns, people invest more in bonds  Demand for Bonds Increases, i.e., Bond Demand Curve Shifts to the Right

19. Shifts in demand for bonds occur due to changes in • .Risk of Bonds Relative to Other Assets • When Bond Riskiness increases, people move investments away from bonds into other assets  Demand for Bonds Decreases, i.e., Bond Demand Curve Shifts to the Left

20. Shifts in demand for bonds occur due to changes in • .Liquidity of Bonds Relative to Other Assets • When Bond Liquidity increases, people invest more in bonds  Demand for Bonds Increases, i.e., Bond Demand Curve Shifts to the Right

21. Shifts in the supply of bonds occur due to • Expected Profitability of Investment Opportunities • When expected profitability of investment opportunities increases, firms want to make bigger investments. To finance these increased investments, more bonds are issued. Therefore, the supply curve for bonds shifts to the right.

22. Shifts in the supply of bonds occur due to • Expected Inflation • When inflation is expected to be high, the real rate of interest is expected to be low. Therefore, firms want to borrow more. This shifts the bond supply curve to the right.

23. Shifts in the supply of bonds occur due to • Government Activities • Increased government activities imply increased government spending which has to be financed by issuing more Treasury debt. Thus the bond supply curve shifts to the right.

24. Changes in Equilibrium Interest Rates • Changes in expected inflation: • Bond Demand Curve shifts to the Left • Bond Supply Curve shifts to the Right • Interest Rate Increases • Fisher Effect

25. Changes in Equilibrium Interest Rates • Business Cycle Expansions • Bond Demand Curve shifts to the Right • Bond Supply Curve shifts to the Right • Quantity of Bonds Increases • Interest Rate may Increase or Decrease • Empirical evidence indicates that interest rate increases

26. Liquidity Preference Framework • Alternative Method for determining Interest Rates • Closely related to (alternative representation of) the Loanable Funds framework

27. Basic Assumption: All individuals hold their wealth either as interest earning assets (bonds) or as non-interest earning cash. • Bonds are desirable because of the interest they earn • Cash is desirable because of the liquidity. • Therefore, allocation between bonds and money represent a trade-off between interest income and liquidity demands.

28. Demand Curve for Money • If interest rates are high, more wealth will be held in bonds • If interest rates are low, more wealth will be held as liquid money, because the opportunity cost, i.e., the income foregone, is low.

29. Supply Curve for Money • Supply of Money is Unilaterally fixed by the Central Bank. For USA, it is the Federal Reserve System. • At equilibrium, money demand = money supply

30. Shifts in Demand for Money • Income effect: Increase in income increases the amount of money individuals want to hold. Therefore, an increase in GNP/Income shifts the money demand curve to the right. • Price Level Effect: Increases in price levels reduce the real value of money. Therefore, more money is held by individuals, thus shifting the money demand curve to the right.

31. Shifts in Supply of Money • Supply of money is controlled by the Federal Government through the Central Bank. Money Supply is thus an important tool used by the Fed in trying to control the economy.

32. Changes in Equilibrium Interest Rates • Changes in Income • Money demand curve moves to the right • Money supply curve remains at previous level • Interest rate increases

33. Changes in Equilibrium Interest Rates • Changes in price level • Money demand curve moves to the right • Money supply curve remains at previous level • Interest rate increases

34. Changes in Equilibrium Interest Rates • Changes in Money Supply • Money demand curve remains at previous level • Money Supply curve shifts to the right • Interest rate decreases.

35. Impact of changes in Money Supply on Interest Rates has been a topic of controversy. In addition to the direct liquidity effect above, other effects have also been hypothesized. •  Income Effect: Increase in money supply increases demand for money and thus shifts the demand curve to the right, thereby increasing interest rates. •  Price-level Effect •  Expected Inflation Effect • These 3 effects work against the liquidity effect on the direction of interest rate movements. In reality, the final outcome depends upon which effect is stronger and which one comes into play earlier.

36. TERM STRUCTURE OF INTEREST RATES • Bonds which are otherwise identical but have different maturities have different yields-to-maturity (YTM). • Yield Curve: Curve depicting YTM of par bonds as a function of their maturities.

37. Term Structure: Curve depicting the yields on Zero-Coupon Bonds as a function of their maturities. • Yield Curves and Term Structures take on a variety of shapes: upward sloping, downward sloping, flat, humped, inverted humped, etc. Most often, however, the Yield Curve is upward sloping.

38. What explains the shape of the Yield Curve? •  Expectations Hypothesis •  Preferred Habitat Hypothesis •  Liquidity Preference Hypothesis.

39. Expectations Hypothesis • “The interest rate on a long term bond equals the average of short-term interest rates that people expect to occur over the life of the long-term bond.” • Example: The interest rate on a 5 year bond will equal the average of interest rates on the 5 successive 1 year bonds starting today.

40. Expectations Hypothesis • Upward sloping Yield Curve denotes the market’s expectation that short-term interest rates will rise in the future • Downward sloping Yield Curve denotes the market’s expectation that short-term interest rates will decline in the future • Flat Yield Curve denotes the market’s expectation that short-term interest rates will remain stable in the future.

41. Expectations Hypothesis • Simple theory that explains the empirically observed phenomenon of interest rates of different maturities moving together over time. • However, it is difficult to explain the fact that the Term Structure is upward sloping most of the time. This would seem to indicate that short term interest rates should be rising most of the time. However, in an efficient market, they should be as likely to move up as down. This is a serious weakness of the Expectations Hypothesis.

42. Preferred Habitat Hypothesis • “The market for bonds of each maturity is largely separate and segmented from the markets for bonds of all other maturities. The equilibrium interest rate in each maturity bond market is established by demand and supply in that market alone, with absolutely no across-market effects.”

43. Preferred Habitat Hypothesis • Not a very satisfactory theory. • Does not explain the smooth nature of observed Yield Curves • Does not explain the comovements of several interest rates.

44. Liquidity Preference Hypothesis • “The interest rate for a long term bond equals the average of short-term interest rates expected to occur over the life of the long-term bond plus a term premium that depends upon demand and supply for bonds of that term.”

45. Liquidity Preference Hypothesis • Emphasis on liquidity: Investors prefer to hold more liquid, i.e., shorter term bonds. Therefore, they need a higher return, or a term premium, on longer term bonds. • Satisfactory explanation for the normally observed upward sloping nature of the term structure.

46. Liquidity Preference Hypothesis • A sharply upward sloping Yield Curve denotes the market’s expectation that short-term interest rates will rise in the future • A flat or downward sloping Yield Curve denotes the market’s expectation that short-term interest rates will decline in the future • A moderately upward sloping Yield Curve denotes the market’s expectation that short-term interest rates will remain stable in the future. • Synthesis of the previous two theories.